The Global Economy and Policy - Macroeconomics

Macroeconomics in Context, Fourth Edition The Global Economy and Policy Do you know how many Philippine pesos, South African rand, or Peruvian nuevos soles you can get for a U.S. dollar? No? If you traveled to one of these countries, you might be surprised to find out that the average person on the street in any city can often easily quote you the going exchange rate between their currency and the U.S. dollar. People in smaller economies have always been very vulnerable to international economic conditions and hence make it a habit to stay current on the rate. In contrast, because the United States has a large economy and its currency has historically dominated the world financial system, people living in the United States often tend to be relatively unaware of global economic conditions. But this has been changing, as recent events have made increasingly clear the degree to which national economies are interdependent. Global financial imbalances exposed first by the 2007– 8 financial crisis, and more recently by the global COVID-19 pandemic, led to world economic downturns that weakened the relative standing of the U.S. economy. Thus far, the dollar remains the preeminent international currency, but there is continuing discussion about possible alternatives. International money flows, as we will see, are partly determined by international trade flows. The U.S.–China trade imbalance continues to be a concern, with many arguing that the large U.S. trade deficit means that the United States owes too much money to China and that this will cause economic problems in the future. The great size of the U.S. economy makes it more capable of handling its indebtedness—both domestic and international—than many smaller countries. But many developing countries around the world face immense economic and financial challenges, with international debts far greater than their GDPs. Other political events, such as Britain’s exit from the European Union and inflation in Turkey and Argentina, have also led to fluctuation in national currency values. How can we evaluate these and similar issues from an international economic perspective? 1 Macroeconomics in a Global Context In earlier chapters, our macro model has generally limited its scope to the three main economic sectors: households, businesses, and the government. We have seen how each of these—through consumption, investment, and government spending— contributes to aggregate expenditure. It is now time to open things up a bit and introduce the foreign sector. Doing so can provide insight into how national economies are linked, and also into the opportunities and problems that such linkages can create. 1.1 Global Connections An economy with no international linkages is called a closed economy, while one that participates in the global economy is called an open economy. The economic linkages among countries can take many forms, including: • international trade flows, when goods and services that have been created in one country are sold in another, or when multiple countries are involved in different stages of production as part of a global supply chain. DRAFT 1 • international income flows, when capital incomes (profit, rent, and interest), labor incomes, or transfer payments go from one country to another • international transactions in assets, when people trade in financial assets such as foreign bonds or currencies, or make investments in real foreign assets such as businesses or real estate • international flows of people, as people migrate from one country to another, either temporarily or permanently • international flows of technological knowledge, cultural products, and other intangibles, which can profoundly influence patterns of production and consumption, as well as tastes and lifestyles • international sharing of, and impact on, common environmental resources, such as deep-sea fisheries and global climate patterns • the institutional environment created by international monetary institutions, international trade agreements, international military and aid arrangements, and banks, corporations, and other private entities that operate at an international scale. global supply chain: A network of countries directed at transforming resource inputs into finished products for delivery to the consumer. Any one of these forms of interaction may be crucially important for understanding the macroeconomic experience of specific countries at specific times. Mexico and Turkey, for example, receive significant flows of income from remittances sent home by citizens working abroad. Trade in “intellectual property,” such as technology patents and music copyrights, continues to be an issue of hot dispute. And as made clear by the COVID-19 pandemic, diseases that threaten human health or pests that damage agriculture can travel along with people and goods—with grave consequences. Thoroughly describing the international economic system is too large a project for even a whole textbook, never mind one or two chapters. This chapter will therefore focus on the critical foundational material required to understand the global economy. It looks at two distinct but interrelated phenomena: trade, or specifically how trade in goods and services affects aggregate expenditure; and finance, or the flows of money across borders for commercial as well as investment purposes. Additionally, we look at how trade and finance influence the exchange rate of a country’s currency. As we will see, these international issues can all affect living standards and macroeconomic stabilization. Later chapters look in more detail at issues of growth and sustainability. 1.2 Major Policy Tools We say that a country’s economy is “open” if it exports and imports large amounts relative to its GDP and “closed” if it exports and imports relatively small amounts. Governments can try to control the degree of openness or “closedness” of their economy through a variety of policy tools. Yet why would a country even want its economy to be “closed?” Is trade with other countries not unambiguously favorable? Those who favor globalization believe so; those more inclined to “protectionism” are more skeptical. DRAFT 2 The traditional view, which dates back two centuries to Adam Smith and David Ricardo, is that trade is indeed an unmistakable benefit. One of the chief supporting ideas is that through trade, a country can expand the market for its products and therefore increase the benefit of specializing in products in which it has a productive advantage. Specialization, moreover, is seen as promoting productive efficiency and thus helping to increase economic output. Finally, through trade a country can translate its improved productivity to greater consumption of a variety of relatively lowpriced products available from other countries—hence achieving higher living standards. While there is a strong economic argument to support such claims, trade skeptics focus on the potential problems. First, trade can sometimes leave a country exceedingly vulnerable to market changes and instability. If, for example, the price of a critical raw material or food item unexpectedly rose and a country specializing in other products no longer produced that item domestically, the country might suffer severe adverse consequences if unable to pay the higher price. Second, it matters in what products a country specializes. If a country focuses on aircraft and other high-tech products, for example, there is not necessarily a problem as long as it finds sufficient external market demand for these items. On the other hand, if a country specializes in producing bananas and coffee, there are two potential problems. First, such items often yield relatively meager earnings and employment potential, even if trade with other countries is extensive. Second and more problematic, planning an economy around the production of such primary products commits a large portion of the country’s valuable resources to the production of such goods, seriously hampering a country’s potential to become richer and more diversified. Trade can also lead some countries, especially those that are poor, to maintain low standards for worker or environmental protection. Lower standards make for “cheaper” production, hence more competitive prices. While richer countries on the whole have lower tolerance for labor and environmental abuses, countries with impoverished populations will sometimes regard lax or even non-existent regulation in these areas as the “price” of trade competitiveness. Finally, even if trade produces generalized benefits for all participating countries, it does not mean that everyone within a country benefits. In particular, workers in importcompeting industries may face lower wages or job loss as a result of cheaper imports. Perhaps the most common example given for restricting trade (often labeled protectionism) is that doing so protects domestic workers’ jobs—even if at the cost of limiting domestic consumer choice. protectionism: the practice of limiting the extent of trade with other countries through direct policy intervention Because of such controversies, as well as others, few if any countries adopt completely “open” policies. Various restrictions on trade have remained common even as global trade has expanded. What are some of the ways in which a country can restrict trade? One means of doing so is a trade quota, which does not eliminate trade but sets limits on the quantity of a good that can be imported or exported. By restricting supply, a quota generally raises the price that can be charged for the good within the country. This helps domestic producers of the good by shielding them from lower-price competition. It hurts foreign producers because it limits what they can sell in the DRAFT 3 domestic market. Some foreign producers may, however, get some benefit in the form of additional revenues from the artificially higher price. trade quota: a restriction on the quantity of a good that can be imported or exported A second sort of policy—which has been used often throughout history and which is still the most widely used tool of trade policy—is a tariff (or “duty”). Tariffs are taxes charged on imports or exports. Tariffs, like quotas, can reduce trade because they make internationally traded goods more costly to buy or sell. Often misunderstood, tariffs are taxes paid to the government of the importing country by the importing company or entity, not by the exporting country. Even if a country wanted to tax its trading partners, it would have no manner of compelling them to pay. Taxing the country’s own importing entity nevertheless discourages trade with the other country since the product price goes up. Consumers are therefore the ones who ultimately “pay” for the tariff in the form of a higher retail price. tariffs: taxes on imports or exports Like quotas, import tariffs benefit domestic producers while raising prices to consumers. Unlike quotas, however, tariffs provide monetary benefit to the government that imposes them. Also, they do not give foreign producers an opportunity to increase prices—in fact, foreign producers may be forced to lower prices in order to remain competitive with domestic producers that do not pay the tariff. There are also various non-tariff barriers to trade that can be imposed. These include the use of specific licensing requirements, standards, or regulations on imported goods, which permit trade but may limit its extent. These may take the form of “disguised” trade barriers that are not always easy to distinguish from reasonable standards or regulations. Perhaps as a consequence, we have seen quite a variety of such non-tariff trade barriers. One well-known case was a German law requiring all the beer that the country imports to be made of a few select ingredients (namely water, barley, and hops). Beer “purity” might have been a plausible pretext, but in 1987 the European Court of Justice found the centuries-old law to be in violation of commercial agreements among European Union member countries, and Germany was required to admit imports of beer that was not “pure.” Eventually, Germany even permitted domestic production of “impure” beer, as long as it was not labeled “beer.” non-tariff barriers to trade: use of licensing or other requirements to limit the volume of trade The last important major category of trade-related policies—trade-related subsidies—may be used to either expand or contract trade. These are increasingly prevalent as less “visible” alternatives to tariffs or quotas. Export subsidies, paid to domestic producers when they market their products abroad, are motivated by a desire to increase the flow of exports. Countries can also use subsidies to promote a policy of import substitution, by giving domestic producers extra payments to encourage the production of certain goods for domestic markets, with a goal of reducing the quantity of imports. DRAFT 4 trade-related subsidies: payments given by governments to producers to encourage more production, either for export or as a substitute for imports import substitution: the policy of subsidizing domestic producers to make products that can be used in place of imported goods Government policies can also influence international capital transactions (financial flows). Central banks often participate in foreign exchange markets with policy goals in mind, buying or selling foreign currencies, as discussed in detail later in this chapter. Countries also sometimes institute capital controls, which are restrictions or taxes on transactions in financial assets such as currency, stocks, or bonds, or on foreign ownership of domestic assets such as businesses or land. Restrictions on how much currency a person can take out of a country, for example, are one type of capital control. More sweeping capital controls can restrict investment flows into or out of a country, sometimes based on the concern that rapid large investment flows could destabilize the domestic economy. capital controls: the regulation or taxation of international transactions involving assets Countries may also regulate the form that foreign business investments can take. Some have required that all business ventures within their borders be at least partially owned by domestic investors. Some have required that all traded manufactured goods include at least a given percentage of parts produced by domestic companies. Countries that have adopted such domestic content requirements include China, Indonesia, Mexico, and the Philippines; the 2020 U.S.-Mexico-Canada Agreement (USMCA) also contains a regional content requirement. Sometimes such controls are related to a development strategy, while in other cases they simply reflect a desire to avoid foreign domination of domestic markets. domestic content requirement: laws requiring traded goods to contain a certain percentage of goods produced by domestic companies Some trade policies are enacted to try to attract foreign investment by, for example, giving foreign companies tax breaks and other incentives. A popular form of this is the foreign trade zone, a designated area of the country within which many tax, tariff, and perhaps regulatory policies that usually apply to manufacturing are suspended. By attracting foreign investment, countries may hope to increase employment or gain access to important technologies. A well-known example is the maquiladora policy in Mexico under which manufacturing plants can import components and produce goods for export free of tariffs. U.S. companies on the other side of the border also benefit from Mexican exports made with much cheaper labor. Maquiladoras and similar foreign trade zones are controversial; critics highlight their frequent labor rights violations, exceedingly low wages, and environmental pollution. Mexican maquiladoras today face far more competition than 30 years ago. Other countries with an abundance of low skilled labor, like China, India, and Pakistan, are now a much bigger factor in the global economy than they once were. DRAFT 5 foreign trade zone: a designated area of a country within which foreign-owned manufacturers can operate free of many taxes, tariffs, and regulations Migration controls are another important aspect of international policy. Countries generally impose restrictions on people who visit or move to their territory, and a few also impose tight regulations on people when leaving the country. Although beliefs about national culture and population size are often the most obvious concerns behind the shaping of these controls, economic interests also play an important role. For example, policies may be affected by concerns about the skill composition of the domestic labor force, the issue of a “brain drain” of skilled workers, or concern about immigrants competing for jobs with domestic workers. But migration controls may create their own problems. For example, Brexit brought about the end of unrestricted labor flows from the European Union to Britain. While hailed by some supporters, this has led to severe labor shortages in a number of British industries. More generally, some labor economists argue that aging populations in many industrialized countries will eventually require an influx of young workers from other countries, merely to support the growing ranks of pensioners economically. Finally, intensifying climate change almost ensures that international migration will increase over time regardless, as populations abandon homes made inhospitable by rising sea levels, dangerously high temperatures, and other climate-related disasters. migration controls: restrictions on the flow of people into and out of a country Countries do not necessarily choose sets of policies that consistently lead toward openness or consistently toward “closedness.” Often there is a mix—policies are chosen for a wide variety of reasons and can even be at cross purposes. Nor do countries choose their policies in a vacuum. Not only must policymakers take into account the preferences of their country’s population, but they must also consider reactions to their policies by foreign governments. Increasingly, they also need to pay attention to whether their policies are in compliance with international agreements. 1.3 Patterns of Trade and Finance Economists would say that national economies are, on the whole, more “open” than in the past, even if global trade has trended slightly downward in the past few years. One way of measuring a county’s economic “openness” is to calculate the sum of its imports and exports of goods and services as a percentage of GDP. Growth in trade according to this measure is shown for 1970–2020 in Figure 13.1. Although trade is a lower proportion of GDP in the United States than in many other countries, a similar pattern of significantly increasing trade over the period 1970-2010 is also evident for the U.S., with a slight downturn in the 2010-2020 decade. Why has trade grown over time? The first and probably most important reason is that many governments have, over time, lowered their tariffs and other barriers to trade. Since the end of World War II, there has been a push for freer trade at the global level. The General Agreement on Tariffs and Trade (GATT), established in 1947, and the World Trade Organization (WTO), succeeding it in 1994, have overseen many rounds of tariff reduction. The WTO, with 164 member countries DRAFT 6 representing over 98 percent of global trade and GDP, also serves as the world’s arbiter on trade disputes. It has thus far consistently ruled against countries engaging in trade restrictions and aims for a world in which countries cannot discriminate against one another through unfavorable trade policies. Despite general agreement on these broad principles, the WTO has often run into difficulties and disagreements among member nations, especially on issues such as agricultural trade. This may have contributed to the recent stall in expansion of global trade evident in Figure 13.1. World Trade Organization: An international organization that conducts negotiations aimed at lowering trade barriers, and mediates trade disputes between countries Figure 13.1 Trade Expressed as a Percentage of Production, World and United States, 1970–2020 Note: Since this measure includes both imports and exports, it does not mean that over 50 percent of all produced goods and services in the world are traded—it counts the same goods both as exports from one country and imports to another. Further complicating matters is the existence throughout the world of so-called “trade blocs”—groups of countries integrating their economies for commercial advantage. Members of a trade bloc grant preferential market access to other participants, usually within the same geographical area. Such economic integration effectively creates a hierarchy of trade preference in which bloc members are favored—with, for example, elimination of tariffs or quotas—even if the goods traded are produced less efficiently or competitively than they could be outside the bloc. It could therefore be said that trade blocs, while promoting free trade within a specific region, countervail the main objectives of the WTO. DRAFT 7 The United States-Mexico-Canada Agreement (USMCA) * is an example of one type of trade bloc that is known as a free trade area. The participating countries agree, among other things, not to impose tariffs on imports from each other. Members can pursue independent trade policies with countries outside the free trade bloc (for example, Canada has a separate trade agreement with the European Union). A customs union is a free trade area that goes one step further: It also defines common tariffs towards the rest of the world. The Southern African Customs Union (SACU), consisting of Botswana, Eswatini (sometimes referred to as ‘Swaziland’), Lesotho, Namibia, and South Africa, is one example. Yet more integrated is a common market, which is like a customs union that additionally provides for free movement of labor and capital, as well as goods and services, among its member countries. The European Economic Area (EEA), which encompasses the European countries, Norway, Iceland, and Liechtenstein, is an example of a common market. An economic union is a common market that, in addition, adopts a common set of economic policies. As an example, the Maastricht Treaty (1992) stipulated “convergence criteria” (fiscal policy requirements) for countries belonging to the European Union. Other examples of such unions are MERCOSUR (Argentina, Brazil, Paraguay, and Uruguay) and the Central American Integration System (SICA). Finally, a monetary union refers to an economic union that additionally shares a single currency. The Eurozone (the region that shares the Euro currency) is the by far most well-known example of a monetary union. Some, but not all, members of the European Union participate in the Eurozone. (Denmark and Sweden are examples of European Union members that do not participate in the Eurozone.) The Eastern Caribbean Currency Union is the only other example of note, and it is a subset of the Caribbean Single Market and Economy (CSME), another economic union. free trade area: A group of countries that have abolished tariffs and quotas for goods produced in the area and traded between these countries customs union: A group of countries that have abolished tariffs and quotas among themselves, and have introduced a common external tariff common market: A group of countries forming a customs union and additionally permitting free movement of labor and capital between participating countries economic union: A group of countries forming a common market and additionally adopts a common set of economic policies economic and monetary union: An economic union in which participating countries share a single currency A second reason for the increase in trade flows is improvements in transportation technology. The costs and time lags involved in shipping products by air, for example, are far less now than in 1950. Fruit from Chile and flowers from Colombia or Costa Rica are now flown into the United States every day—and are still fresh when they arrive. Container ships have hugely reduced the costs of long-distance transport. DRAFT 8 The third reason for increased trade is advances in telecommunications. The infrastructure for phone, fax, and electronic communication has improved dramatically. Better telecommunications make it possible for many kinds of services, such as customer support and many technical functions, to be directly imported from, for example, call centers in India. Figure 13.2 Top Purchasers of Goods from the United States and Suppliers of Goods to the United States, 2021 Figure 13.2 shows the volume of exports that the United States sells to the top eight buyers of its goods and the volume of its imports that come from the top eight countries that sell to it. Historically, the closest neighbors of the United States— Canada and Mexico—have been very important trading partners. Germany, the United Kingdom, and Japan, not surprisingly, have also been leading trade partners. Over the last several decades, China has become a major source of U.S. imports. Until about 1980, U.S. trade with China was negligible. Since then, U.S. importation of Chinese products—especially electronics (including computers and televisions) as well as clothing, toys, and furniture—has boomed. Although China buys some U.S. goods, including agricultural products and aircraft, the value of U.S. imports from China far exceeds the value of U.S. exports to China, creating a trade deficit with China of over $300 billion in 2020. 1.4 Transnational Corporations and Global Supply Chains Trade relations have also grown increasingly complex over time. We have thus far been assuming that countries produce all products from start to finish and then sell them to their trading partners. But as the world’s markets become progressively more interlinked, private companies known as transnational corporations (TNCs) often DRAFT 9 find it advantageous to schedule different stages of production in different countries through global supply chains. So, for example, goods as diverse as automobiles and clothing are often produced in more than one country. The presence of TNCs in multiple countries means that much of the “international trade” that goes on actually occurs within one company. transnational corporation: a company that produces goods or services in more than one country. By organizing production and sale through global supply chains, TNCs gain efficiency advantages that increase profits. They are able to arrange each production stage in a country where, for example, labor or vital resource inputs are cheapest. Doing so helps save them considerable amounts of money. Technological advances in transportation and communications have facilitated this progress. Additionally, sophisticated algorithms have in recent years enabled companies to, for example, better anticipate consumer demand. This means that it is often no longer necessary to spend large sums of money storing inventory, as products are increasingly timed to ship as they are needed. Such developments have, over the years, helped increase the interconnectedness of markets. The efficiency gains of such modern trade networks have greatly helped increase TNC profits. But they have also come under criticism, for example for allowing TNCs to choose to operate where safety or environmental standards are most lax. Global supply chains can also be vulnerable to unexpected events. Today’s computer algorithms, increasingly driven by artificial intelligence or ‘AI,’ have immense computing potential. But when it comes to predicting sudden “shocks” to the system, they often fall short. This was vividly illustrated during the pandemic years of 20202022, as disruptions in some sectors spilled over into others, creating a “domino effect” with substantial adverse impacts on global commerce, prices, and employment. Despite optimism that the worst is over, fear remains that global supply chain problems will persist indefinitely (see Box 13.1). Box 13.1 Global Supply Chain Crisis Could Last Another Two Years Industry experts warn that the pandemic-induced supply chain crisis that began in 2020/2021 could last for up to two years. Many markets are affected. In Britain, for example, it is alcohol; in Canada, maple syrup; in Australia it is a crucial additive for diesel trucks; and in New Zealand it is brown sugar. Maersk, one of the big three shipping companies, said the worst delays were on the US west coast, creating a “ripple effect” around the world. Among consequences are too many containers in some ports in the US and Europe, but not enough in ports throughout Asia. Inflation touched decades-long highs in western economies not only because of higher shipping costs, but due to greater demand from consumers stuck at home for months and unable to spend any money on treats such as holidays and nights out. Tiffany Compres, a partner at international law firm FisherBroyles based in Florida, said: “It will take time to get better, for companies to adjust, and for the legal framework to adapt. To add to the challenge, this is very much a political DRAFT 10 issue, and nations will need to cooperate to really get us to a new sustainable way of operating the supply chain. It seems to be a tall order in our polarized era.” And Dennis Unkovic, a US corporate lawyer, trade expert and author of Transforming the Global Supply Chain, says that for anyone “expecting the postpandemic world to return to ‘normal,’ forget it. Whatever was considered normal before the pandemic is not coming back.”1 Regardless of how the supply chain problem is resolved, there also exists a longerterm political challenge. Concern is growing that TNCs may eventually become so large that they will wield absolute power over the countries that host them. An American or European company might, for example, pressure the government of Brazil to loosen earlier restrictions on deforestation on grounds that more land is needed for cattle ranches or soybean farms. Major agribusiness corporations already wield considerable power over agricultural policy in many African countries. Such cases could mean that private companies would have sovereign rights over the governing of independent countries. As TNCs become more dominant in the global economy, this is not an idle concern. Discussion Questions 1. How do international linkages affect your own life? Can you give examples of the sorts of linkages listed in Section 1.1 that have had direct effects on you or your family? 2. Production of apparel has been widely globalized in recent years. Before going to class, check the labels on a number of items of clothing that you own. Which countries are represented? 2 The Trade Balance: Completing the Picture How does trade affect the economy? In a number of important ways. Consumers who go to any U.S. shopping mall, for example, cannot help but notice that a large proportion of the products available for sale are imported. Many U.S. jobs are in industries that depend on export markets. We often hear concern expressed about the trade deficit. In 2021, the U.S. trade deficit equalled nearly 4 percent of GDP. 2 This means that people in the United States were spending much more on foreign goods and services (importing) than the United States was selling to foreign buyers (exporting). In other words, U.S. net exports (exports minus imports) were negative. In many other countries, the situation is reversed. China, for example, is a large net exporter, meaning that it carries an annual trade surplus. Were it not for the United States, however, China would be a much smaller net exporter. Of its $366 billion in net exports in 2020, about $286 billion consisted of its bilateral surplus with the United States. 3 trade deficit: an excess of imports over exports, causing net exports to be negative trade surplus: an excess of exports over imports, causing net exports to be positive DRAFT 11 2.1 The Circular Flow Revisited Our trade balance is also related to the circular flow discussed in earlier chapters. In this section, we look at the impact of our exports and imports on aggregate expenditure and GDP. We can introduce trade into our macroeconomic model by adding net exports (NX) into the equation for aggregate expenditure: AE = C + II+ G + NX As discussed in Chapter 4, net exports (NX) equals exports minus imports (X – IM). Exports, like intended investment (II) and government spending (G), represent a positive contribution to aggregate expenditure. More exports means more demand for domestically produced goods and services. Imports, however, are a negative in the equation. That means they represent a leakage from U.S. aggregate expenditure—a portion of income that is not spent on U.S. goods and services. Negative net exports (when X < IM) therefore represent a net subtraction from demand for the output of U.S. businesses and a net leakage from the circular flow. In Chapters 8 and 9, we identified savings and net taxes as leakages from the circular flow; now we need to add imports as a third source of leakage. We can also add exports to intended investment and government spending as a third source of injection into the circular flow. A decrease in exports (or an increase in imports) reduces the circular flow of domestic income, spending, and output. An increase in net exports, on the other hand, encourages a rise in GDP and employment. For example, an increase in U.S. purchases of foreign cars and a decrease in purchases of domestic cars would lower aggregate expenditure in the United States (and raise it in other car-exporting countries). But an increase in foreign sales by the U.S. computer software industry would raise U.S. aggregate expenditure and employment. Adding exports and imports completes our basic macroeconomic model. We started with a very simple economy, with just consumers and businesses, then added government spending, taxes, and the international sector. We now have a more complex model, with three leakages (saving, taxes, and imports) and three injections (intended investment, government spending, and exports). Imports are considered leakages because, like saving and taxes, they draw funds away from the domestic income-spending flow. Exports, like intended investment and government spending, add funds to the flow. We can modify our original circular flow diagram to show all these flows (Figure 13.3). Macroeconomic equilibrium thus involves balancing the three types of leakage with the three types of injection. A change in one or more of the leakages or injections alters the equilibrium level of output. This equilibrium, however, is a moving target. The equilibrium to which the economy tends depends on the interaction of all leakages and injections, which are constantly changing. For instance, an increase in foreign car imports lowers the equilibrium level that would balance the economy. But this change might be offset by, for example, an increase in intended investment or government spending. The model that we have constructed allows us to understand how all these factors are related to levels of income and employment. We put it to use shortly to explain how saving and investment are linked to the global economy. But first we look at the multiplier effects of exports and imports. DRAFT 12 Figure 13.3 Leakages and Injections in a Complete Macroeconomic Model 2.2 Effects on the Multiplier The multiplier effect for an increase in exports is essentially the same as that for an increase in II or G. Using the same model as in Chapter 9 (with a multiplier of 5), an increase of exports of 40, for example, leads to an increase of 200 in economic equilibrium. ∆Y = mult ∆X We can use exactly the same logic for a lump-sum increase in imports—the effect on equilibrium income just goes in the opposite direction. An increase in imports of 40 would lower the equilibrium level of income by 200, and a decrease in imports of 40 would raise the equilibrium by 200. The multiplier logic becomes a little more complicated, however, when we consider how import levels are determined. In general, when people receive more income in an open economy, they spend some of it on domestically produced goods and some on imports. The proportion spent on imports, as we noted above, is a “leakage” that does not add to domestic demand. If we want to account for this fully, we need to modify our multiplier logic. The effect is similar to that of a proportional income tax (see Chapter 9, Appendix 2): it tends to flatten the aggregate expenditure curve, for the same reason. When people receive additional income, a portion of it “leaks” away into imports, just as taxation causes a “leakage” of a portion of extra income. This portion does not stimulate the domestic economy, so multiplier effects are smaller and the economic response a bit less dynamic. Multipliers in the neighborhood of four or five are seldom observed in the real world, because mpc is affected not only by our marginal propensity to save but also by the rate of taxation and our marginal propensity to import. For a full treatment of this effect, see the Appendix to this chapter. DRAFT 13 In an open economy, a portion of any aggregate expenditure increase goes to stimulate someone else’s economy via imports. Thus, U.S. consumers who buy imported goods from Canada are creating jobs and income in Canada, not the United States. Does this mean that imports are bad for the United States? Not necessarily. Two other factors are important to consider. The first is that U.S. consumers and U.S. industry benefit from cheaper imported goods and services, raw materials, and other industrial inputs. The second is that at least some of the money spent on imports is likely to return to the United States either as demand for U.S. exports—which, as we have seen, stimulates an increase in GDP and employment—or as foreign investment in the United States, which is generally beneficial to the U.S. economy overall. More generally, the U.S. economy, and overall quality of life in the United States, improves when other countries have healthier economies and diminishes when other countries are suffering economic setbacks. A prosperous world is a happier world for all. Thus, in the largest sense, if China or Canada benefit from exporting to the United States, to some extent this benefits everyone. Problems can arise, however, when trade deficits (negative net exports) are too large for too long. We explore this issue in more detail later in the chapter. 2.3 Balance Between Savings, Investment, and Net Borrowing We can use our macro model to demonstrate that saving and investment are related not only to net exports but also to foreign lending and borrowing. Understanding this link is critical to making sense of much that happens in the global economy. We start with the usual equation breaking down GDP into consumption, investment, and government spending. In addition, we follow the convention—seen earlier in Chapter 4—of breaking government spending down into “government consumption” and “government investment,” which results in the following equation: GDP = Personal consumption + private investment + government consumption + government investment + net exports or GDP = C + II + GC + GI + NX Rearranging, we obtain GDP — C — GC = II + GI + NX Because saving is what is left over from income after spending on consumption (the left-hand side of the equation above), if we combine private and government savings* into a single term Stotal and private and government investment into a single term Itotal, we get: or: Stotal = Itotal + NX Total saving = Total investment + net exports DRAFT 14 Thinking about these quantities in terms of valuable goods and services, this important identity says, intuitively, that goods and services that are produced in our domestic economy in excess of what we currently use for consumption can become investment goods—additions to our stock of manufactured assets (including replacement of depreciated assets)—or can be sold to foreign countries (in excess of the value of what we import from them). Another way of understanding this is in terms of macroeconomic equilibrium. If, say, total domestic saving exceeded investment, a net leakage from the circular flow would occur. In order to obtain an equilibrium, this leakage would need to be offset by a trade surplus (an excess of exports over imports, creating a net injection). If total investment exceeded saving, the opposite would result—that is, there would be a trade deficit. In this case, the net leakage from an excess of imports over exports would balance the net injection caused by investment exceeding savings. Yet another way to look at the relation of saving, investment, and trade is to think of how the various sectors finance their purchases of goods and services. In a contemporary economy, goods are rarely traded for goods; rather, money is used as a means of exchange. So, corresponding to any flow of goods and services transacted in exchanges, there is an equivalent flow of monetary funds. Consider, for a moment, a closed economy. In this case the last equation would reduce to: Stotal = Itotal This says that, in a closed economy, the total amount that is not spent on consumption goods is available for spending on investment goods. How does financial saving get turned into tangible investments? In the national accounts, it is primarily businesses and the government that are counted as investing (although households may also “invest”, for example in second homes). They finance their investment expenditures either from their own savings or by borrowing someone else’s savings (by getting a loan from their commercial bank). Savings, in the form of income not spent on consumption, can be made available for investment by the other sectors—as when the funds in a household’s bank deposit are lent to a business or when a household or business buys a government bond. The “saving = investment” identity tells us that at an aggregate national level in a closed economy, only what the country as a whole saves out of current income can be available to finance investment for the future. When we consider an open economy, things get more complicated. Now the country as a whole can also borrow from, or lend to, the foreign sector, and the relevant identity, as noted above, is: Stotal = Itotal + NX If net exports are positive, we sell more goods abroad than we buy. How would people abroad pay for all our goods, if the value of what we sell to them exceeds the value of what they sell to us? They are not earning enough from their sales to pay us! The main way for them to finance their purchases of our goods is by borrowing from us. They would need to borrow the amount by which our exports to them exceed our imports from them. So, the identity can be (approximately) rewritten as: DRAFT 15 Stotal = Itotal + net foreign lending That is, if we have extra savings, above and beyond what is being used for domestic investment, we can lend it to foreigners so that they could buy our goods. The equation above is only approximate, because foreigners can also get more goods and services from us than they sell to us by receiving our goods as gifts, paying for them out of transfer income, or selling us their assets, such as land or businesses, in return. We discuss these possibilities in greater detail in the next section. In recent years the United States has tended to have net exports that are negative. That is, we tend to buy more from foreign countries than we sell. This means that we need to borrow from them. In this case, we can rewrite the savings/investment identity as: Stotal = Itotal – net foreign borrowing (This means exactly the same thing as the previous equation but is easier to use to represent a situation with a trade deficit.) When we are in a situation of borrowing from abroad, then the amount we are really “putting away for the future”—that is, saving—is less than what we would assume if we looked only at what we are investing. Although we may be investing domestically, if we are using “net foreign borrowing” to obtain investment funds, we are also creating future indebtedness to other countries by borrowing from them. Should we worry that our country has to borrow from foreigners? As in the case of your personal finances, it makes a difference what the purpose of the borrowing is. If the borrowing financed the purchase of productive new private or government investment goods, then it might be a way of actually improving the country’s outlook for the future. As mentioned in Chapter 1, for many decades international authorities encouraged low-income countries to borrow heavily for development projects, using exactly this reasoning. But if the funds borrowed went largely into investments that did not pay off financially, or if the borrowing only financed a high level of consumption, there would be reason to worry. A country that borrows a lot may be in trouble when it comes time to pay back its loans. In recent years, some countries have found themselves unable to pay even the interest on the foreign debts that they have built up over the years— much less repay the principal. In the case of the United States, the country’s creditworthiness has not been seriously questioned, and to date paying interest and principal on foreign debt (known as “servicing” the debt) has never posed problems. However, as discussed further in Chapter 15, a high level of international indebtedness has potential costs over the long term. Discussion Questions 1. What will be the likely effect of increased imports on U.S. GDP? Do imported goods undercut employment in the United States? What other developments in the economy might counteract this effect? 2. Savings, imports, and taxes are all considered “leakages” from aggregate expenditure. Are they bad for the economy? Or is there an important function for each? How are their levels related to equilibrium GDP, income, and employment? DRAFT 16